Insurance Probabilities
Economically Feasible Cost
To be insurable, the chance of loss must be small. The cost of an insurance policy consists of the pure premium, or amount actually needed to make loss payments, and the expense portion. If the chance of loss approaches 100%, the cost of the policy will exceed the amount that the insurance company is obligated to pay under the contract.
For example, it would be possible for a life insurance company to issue a $1,000 policy on a man 99 years of age. The net premium alone, however, would be about $980, to which would have to be added an amount for expenses which would bring the premium total to more than the amount of insurance. To make life insurance rates attractive, the premium has to be far less than the face of the policy.
Chance of Loss Must Be Calculable
Some probabilities of loss can be determined by logic alone-for example, the probabilities involved in the flip of a coin. Others must be determined empirically, that is, by a tabulation of past experience with a projection of that experience into the future.
All types of insurance probabilities are determined on an empirical basis. There are some chances of loss, however, which cannot be determined either by logic or from past experience. Unemployment is an example. Unemployment occurs with such a degree of irregularity that, as yet, no one has succeeded in working out a method of determining its future incidence.
This is one reason why unemployment insurance is not sold by private insurance carriers. If there are no available statistics on chance of loss, it is impossible to predict losses, in spite of a large number of exposures.
Unlikely to Produce Loss to Majority Simultaneously
No insurance company can afford to insure a type of loss which is likely to happen to any great percentage of those exposed to it. True, life insurance companies insure their policyholders against death even though it is well established that every one of them will die eventually.
The life insurance company is really insuring its policyholders against premature death. Its rates and reserve accumulations are fixed in such a way that it can pay claims as the claims mature without causing financial hardship to the company.
If all the policyholders of a life insurance company should die prematurely, this company would be just as bankrupt as would a fire insurance company whose policyholders all lost their houses by fire.
Unemployment runs aground on this last barrier, too. Those individuals whose jobs were secure could never be sold unemployment insurance. Prospective customers would be drawn solely from those who felt their employment situations to be insecure.
When a business recession occurred, hosts of the insureds would lose their jobs at the same time. It would be equivalent to a life insurance company having a large percentage of its insureds die at the same time.
Insurance is an arrangement whereby the unfortunate few who lose are indemnified by the fortunate many who escape loss. Particularly those whose financial well being depends on it, which is often the case with the families of term life insurance policyholders. If the many, however, suffer the loss, then the few will prove inadequate to indemnify them properly, except at an uneconomic premium.
In order to guard against catastrophic losses, fire insurance companies, for example, seek a wide distribution of exposures and set up underwriting standards which prohibit the concentrations of business in small sections of a city. They also put a clause in their policies excluding losses due to wars, thus relieving them of the danger of catastrophic losses resulting from atomic warfare.
By: Sarah Martin